Russian banks have risen from the depths of the economic and financial crisis that started in August 1998.

The domestic economy is expanding steadily for the first time in years. Bank balance sheets and business flows moved upward throughout the year 2000 and into 2001, rebounding from the difficult period of absorbing the shock of the collapse and massive bank failures triggered by the crisis.

But no fundamental changes in the Russian banking industry have occurred since then. The retail giant Sberbank continues under state control, private-sector banks remain beholden to the interests of their industrial shareholders, the legal and regulatory environment is still weak and arbitrary, financial disclosure limited, and little foreign direct investment (with corollary inflow of technology and know-how) has come to Russian banks. Russian credit culture remains stunted. A consequence of these factors is that banking intermediation, essential for the efficient accumulation and reinvestment of capital, is woefully undeveloped in Russia, and banks continue to carry a higher degree of credit risk than in almost any other country in the world (see table for list of Russian bank Counterparty Credit Ratings).

The banking industry is one the weakest economic sectors in the Russian Federation. Several factors hinder its improvement (See table below).

The Russian banking system has survived three major crises in its short life since the end of the Soviet Union a decade ago. The first was "black Tuesday" in November 1994, when the bottom fell out of the ruble. The second was the liquidity crisis in the interbank market of August 1995. The third crisis was the government’s default on its ruble bonds and the subsequent ruble devaluation in August 1998.

Most banks in Russia defaulted in the weeks and months following the 1998 crisis; recovery of the banking system began only in the second half of 1999. While the Central Bank withdrew the licenses of many banks after the crisis, the restructuring of the largest failed banks was and has been extremely slow and uneven. SBS-Agro is the most notorious example of this. Survival has depended largely on the strength of a bank’s political connections and links to industrial concerns as opposed to Central Bank policy.

RUSSIAN BANKING INDUSTRY LAGS

Russia's banking sector lags that of other transition economies — for example, Bulgaria, Hungary, Kazakstan, Poland and the Baltic countries — in several key areas. Firstly, in contrast to the situation in these countries, the large state-owned banks in Russia have not been privatized.

Consequently, Vneshtorgbank, and savings bank Sberbank in particular, dominate the retail and corporate banking markets. Both these banks have aggressively expanded business since the second half of 1999. Sberbank benefits from a perceived (but not real) government guarantee on its deposits and the confidence of retail customers, who avoid entrusting their money with private-sector banks.

Its network of 24,500 branches and sub-branches across the Russian Federation dwarfs that of the rest of the sector combined. Sberbank consequently commands over 70 percent of the retail deposit market in Russia (and takes in a monopolistic 86 percent of ruble-denominated retail deposits). Private-sector banks cannot compete on price with Sberbank, in either deposits or lending rates, and must concentrate on better service in order to win business. Sberbank also is the only bank in Russia with enough lending capacity to satisfy the large industrial companies that dominate the economy.

Secondly, limited foreign investment has come to the Russian banking sector, in contrast with the recent history of Bulgaria, Czech Republic, Hungary, Poland, Romania and the Baltic States, among other Central and Eastern European (CEE) countries, where foreigners now control over half the banking market. Russian banks remain in the hands of the government and private domestic companies, themselves usually controlled by a handful of principals. The benefits of foreign direct investment — notably, increased capital and management know-how — have not flowed through the Russian banking system, in contrast to neighboring CEE countries, where foreign direct investment has accelerated the pace of banking reform.

Lastly, the Russian system is highly fragmented and has remained largely unchanged over the past several years. In most transition countries, governments and bank regulators enacted bankruptcy and regulatory reforms, while pushing on several fronts for banks to consolidate regulatory seizure and forced restructuring of failing and uneconomic banks, elimination of restrictions on foreign investment and privatization.RUSSIAN BANKS RATED BY STANDARD & POOR’SCurrent rating in foreign and
local currencies (LT/ShT Outlook)

Alba-Alliance

CCC-/C Negative

Alfa Bank

CCC+/C Stable

Bank Imperial

D/--

Bank Rossiysky Kredit

D/--

Incombank

D/--

Infobank

CCC-/C Stable

Investment Banking Corporation

CCC-/C Stable

Mezprombank

CCC+/C Stable

Petrocommerce

CCC/C Stable

SBS-Agro

D/--For more details, please refer to Russian-language Website www.standardandpoors.ru

It is telling that the wholesale collapse of the Russian banking system in August 1998 did not result in the creation of larger private sector banks. In many cases, the principals of major failed institutions, such as SBS-Agro, Rossiysky Kredit and Menatep, simply transferred assets out of the failed banks to "bridge" banks they also controlled. Creditors of the failed banks were left with just a few kopeks on the ruble. Russian corporate and banking law was not able to manage in an orderly way the bank failures from the most recent crisis.

The history of the domestic forward foreign exchange and option contracts written before the 1998 crisis further illustrates the weakness of the Russian legal and regulatory infrastructure. Authorities in Russia have not been able to settle claims arising from these contracts, now outstanding and unsettled since the crisis. The legal standing of the claims remains unclear; some Russian courts have declared the unsettled forward contracts to be unenforceable gaming contracts. In the absence of any clear ruling, market participants have settled bilaterally on a case-by-case basis, or ignored the issue entirely, waiting for the three-year statute of limitations on the claims to take effect.

Due to the passage of time and the expectation that no further resolution will occur, Standard & Poor’s has lifted SD, or selected default ratings, on banks that have not settled their forward contracts. The SD ratings came to lack relevance in the context of the market, which seeks an opinion on the ongoing creditworthiness of the banks. Nonetheless, the inability of the Russian courts to resolve this issue exemplifies the country's weak and arbitrary legal system – a negative factor constraining the credit ratings of all Russian entities.

FINANCIAL-INDUSTRIAL GROUP MODEL DISFAVORS BANKS

Russian banks continue to be undercapitalized, despite some capital coming recently from industrial enterprises, mainly in the oil and gas sector. In addition, international borrowings remain unavailable, while total deposits are increasing at a slow pace. The absence of longer-term funding, even in the one- to six-month maturity range, is a serious problem for Russian banks (and the Russian economy as a whole). The primary banking activity in Russia is processing settlements among corporations and government entities as opposed to intermediating, i.e. taking deposits and granting loans for working capital. Bank customers place short-term deposits with banks, which often on-lend the deposits at the behest of the depositor, notably for settlements with third parties and for trade finance.FACTORS HINDERING RUSSIAN BANKING SECTOR• Lack of a clear government policy with respect to banking reform• A large unregistered economy that does little business with banks• Lack of trust on the part of depositors with respect to banks• Lack of significant lending business in Russia due to excessively high credit risk• The weak and arbitrary legal system (for example, loan collection is difficult)• The country’s immature credit and payment cultureSource: Standard & Poor’s

Private-sector banks in Russia remain wedded to the financial-industrial group (FIG) model, which clearly has survived intact despite the shock of the crisis of 1998. The dominant strength of the oil and gas industry, and to a lesser extent the metal and armaments sectors, in Russia helps keep the FIG model in place. These industries generate all-important foreign-currency revenues and have an interest in controlling banks to optimize cash flows and reap maximum financial and political advantage from them. This is all the more true in light of Russian companies’ love of elaborate tax-avoidance schemes — a captive bank is a useful tool to manage offshore cash flows. But banks are the expendable part of the FIG in Russia. In the view of the industrial powers, banks are useful for managing cash flows, but not in themselves capable of generating significant revenues. The FIG model is broadly negative for bank credit risk. Owners use banks to finance their other interests, or to fund acquisitions, creating concentrations of risk for the bank. Nonetheless, owners will likely withhold support if it would endanger core industrial holdings. Indeed, this happened in the most recent crisis, when many industrial companies abandoned failing group banks.

Truly independent private-sector banks, with diversified shareholders and diversified customer bases, do not exist in Russia. Alfa Bank, the most Western-oriented of the Russian-owned banks, may have the best chance at achieving a reasonable degree of diversification and independence. But even with Alfa, the goal of building a strong branch-based commercial banking network has not yielded strong results. Alfa’s profits remain concentrated in securities trading and large one-off transactions.

SIGNS OF HOPE

Russian is a relatively open economy with significant ties to global markets. The country is rich in natural resources that constitute its major exports. In the past decade, the integration of Russia into the global economy has increased progressively, despite the severe jolts along the way. The presence of international companies in Moscow and other parts of the country is well-established and appears irreversible. As Russian companies, including banks, do more business with the West, they are pushed to comply with international standards of corporate governance and financial disclosure. Indeed, more and more Russian companies use Big Five auditors and publish their accounts under IAS.

Thus, while the pace of banking reform in Russian is disappointing, external forces are pushing the some banks to accept international standards. This, coupled with the increased business flows from the economic expansion, gives some hope that the huge potential of the Russian banking industry could be achieved in the not-too-distant future. In the meantime, banking reform appears stymied and the credit risk of Russian banks remains extremely high.

(The authors are based in Paris. Scott Bugie can be reached at (+33-1) 4420-6680; Ekaterina Trofimova at (+33-1) 4420-6786.)